Economists Go to War

Well sort of. One of the wonderful aspects of the current crisis is that economists are having to confront reality for a change. That might sound odd, but when you consider that most academic economists have not one whit of experience in the messy goings on of a real economy it takes on a delicious meaning. Most economists nowadays spend their life sublimely cut off from reality and instead inhabit an alternative world of mathematical models. It is a world stripped of all the awkwardness introduced by nasty things like people. In this alternative world you and I could not exist, we are far too limited. No. That world is ruled by ‘agents’ who are supremely gifted, far sighted, and have incredible powers of both memory and computation. While you and I might fumble over the addition in a simple shopping list, these denizens of the economist’s utopia are veritable cognitive gods. Nothing eludes them. Nothing fools them. And above all else nothing shakes them from their determined march towards the idyllic perfection of something called equilibrium.

That none of this resembles, in the slightest way, what goes on in a real economy is of no interest or relevance to academic economists. Indeed they get self righteously indignant whenever someone, an amateur like me for instance, throws cold water on their ‘science’. Call economics voodoo and wait for the hissing from the tenured crowd who preach that market interferences like, well tenure, are a ‘bad thing’.

“If economists are akin to astrologers, which most of them are in my opinion, why should we be interested?”

Of course there are exceptions. Those among them who ‘get it’. These rarities realize that economic theory is, at best, a very weak ‘first approximation’ for reality, and that the outcomes of the models that so enthrall the profession are most often of absolutely no relevance to practical problem solving.

Now I know some of you might be wondering why I bring this all up. If economists are akin to astrologers, which most of them are in my opinion, why should we be interested?

Because they screwed your life up. That’s why. This economic crisis has at its roots an ideological conflict. A war. Between a more realistic economics and the utopian version that has held sway for the past few decades. Had the utopians not won the early battles of the war we may well not have arrived at the mess we find ourselves in.

The Reagan/Bush era is the era also of the triumph of ‘New Classical Economics’. Boring and arcane though it may appear this pernicious and almost entirely useless intellectual construct has permeated into everyday conversation. Anyone one of us who talks of the ‘self-righting capacities’ of markets, or of the ‘proven’ superiority of market allocations over centrally planned allocations of wealth, or of the ‘meddlesome and inefficient’ nature of government, or of the ‘obvious’ inability of government to manage GM, and, in particular, of the ‘need’ to deregulate to set business ‘free’ is aping the New Classical agenda.

The fact is that none of these statements is scientifically correct. Not one. For those of you who remember Econ 101 at college: there is actually no scientific ‘proof’ that supply and demand behave in those nice curves we all drew back then. Behind the scenes there has to be a lot of assumption, guessing, and then leaps of blind faith to make the whole machinery work. Yes it makes intuitive sense. But can it be ‘proved’? Nope. Life is far too complex. Even simple things like that fact that people change their minds about what they like throws the machinery into chaos. The economist’s response? Disallow such things. In the models they use, people, sorry ‘economic units’ to use Milton Friedman’s revealing nomenclature, are not able to change: what they want at seventeen years old is what they want when they are seventy. Bill Gates used to order pizza in his garage while he tinkered with Windows, and he still, according to the models, orders pizza – exactly the same pizza -while he tinkers with Microsoft and his various charitable trusts.

Whoops. As I said: a rough ‘first approximation’ at best.

You might have noticed the recession. It almost slipped into depression. Something evidently went wrong in the economy. One of those things that went wrong was economic theory. Markets apparently foul up now and again. They do not relentlessly focus in on optimal solutions, and then magically and inevitably produce perfection. Sometimes they seem to spin wildly out of control. Heck people even cling onto silly notions like trying to keep their wages high despite rising unemployment – that doesn’t happen in the models.

So economists are going to war.

Not with the intent of developing a new theory that incorporates the messiness of the real world. No. They are going to war with each other. Today’s Financial Times acknowledges as much: it carries an article by Lord Skidelsky trumpeting the behind the scenes violence that has flared up.

The point is this: there are many camps within the world of theoretical economics. Some are more accepting of the real world than others. Some actually tolerate the foibles of real people. Some even allow businesses to make profits – another thing that doesn’t happen in the standard models.

Given the obvious failure of the New Classical system those economists who have been marginalized for the past few decades have suddenly seized the opportunity to grab the headlines. Sometimes they are not even that iconoclastic. Economics is a very gentlemanly world so calling someone, Robert Lucas say, a jerk, is not very nice and therefore not tolerated. Academics being the intensely respectful folk that they are do not go as far as I would. Some would even defend Lucas still for his ‘contribution’.

But let me not pick on Bob.

I should pick on the whole lot of them.

The war that now rages is of great importance to us all. We need economists to understand the economy. It helps us to make policy. If they don’t get their theories right we are left making policy in an intellectual vacuum. This is not trivial. Millions of jobs and livelihoods depend upon the theories that flow from places like the University of Chicago which became the epicenter of the stupidity known as New Classical economics, and which, therefore needs to issue a public apology. Or at least show a little contrition.

Manning the front lines in the war, on the behalf of reality, are a variety of schools of thought. ‘Behavioral’ economists are trying to inject real people idiosyncrasies and psychological fallibilities into economics. Evolutionists are trying to get history and change to be part of the system we examine. There are many others.

But most of all, in the context of the current fight, it is the Keynesians who are emerging as the ‘new wave’. Which means that this war over theory is a re-match. Keynes got it right. The essential observation that sets him apart is his acceptance of the limitations of markets. In his world markets can go wrong. In fact they inevitably will go wrong. This is such an anathema to the New Classicists that they waged war against Keynes for decades until the fortuitous convergence of the 1970’s stagflation, Reaganism, and the collapse of the Soviet Union seemed to hand them the victory. Keynes, with his monetary roots in Wicksell, and his criticism of market purity, along with others with unacceptable ideas, like Fisher, slipped from the textbooks and subsequent generations of students were brainwashed with the notion that markets are inevitably the best solution to all economic problems. The Keynesian tolerance for government intervention was thrown overboard and a strict ‘government is the problem’ dogma took over.

This process of expunging the heretics was covered up and called a ‘merging’: the good ideas from everywhere were brought into the warmth under the covers of the New Classical rubric.

But the ‘synthesis’ looks an awful lot like a deletion. The lessons and theories of the previous era were quietly removed from the curriculum as being quaint or, according to Johnny Cochran, simply ‘fairy tales’. New Classical purity took over. Which is good for the heretics since there is a straight line to be drawn connecting the victory of New Classicism and today’s crisis.

Why?

Because economists were not content with producing theories. They also produced technologies.

Once markets are enshrined as all knowing and supreme the door is opened for all sorts of mischief. Markets must also be ‘efficient’. They must deliver the best solutions. If that is so then the solution we are observing must be optimal since it is an outcome of a market process. This may sound tautological, but it is a summary of something called the Efficient Markets Hypothesis [‘EMH’] which provides the intellectual undergirding for the derivatives market. So economics not only sought to explain the market, but it went further: it provided the techniques, or technology, for running the market. Without EMH the derivatives markets would have remained an arcane backwater. AIG would still be an insurance company and not a failed casino. You and I would never have heard of TARP. Joe Nocera in last weekend’s New York times wrote about the mess that is EMH: this war is going public.

New Classical economists became so sure of themselves that they believed they could shape reality to conform with their models. The application of EMH to options trading is an example of their hubris. And their failure.

Not only this but they declared the mysteries of the business cycle over. As recently as this decade Lucas and his ilk called the days of downturns done with. Alan Greenspan was a true believer. As were most economists with any public stature: it was not possible to attain public stature without bowing to the gods of the market.

This is the extent of the intellectual clean up we are now engaged in. There are years of falsehoods to undo. And huge intellectual reputations to undo as well.

The world has been massively misled by economics. We should all treat it with disdain as it sorts itself out. The New Classicists will not go without a fight: witness the recent public spat, courtesy of the New York Review of Books, between Niall Ferguson and Paul Krugman. But they are in retreat. That’s good news for realists.

And how ironic that New Classical economics may have arrived at its ‘Minsky moment’. Minsky was a Keynesian whose theory talked about asset price bubbles and the inevitable instability of financial markets. That his voice was unknown to so many players in the market is a shame, and may have cost us billions of dollars.

So we can be encouraged: the economists are at war. Sometime in the future they will be worth listening to again.